Why I’m Not Cheering 80% UK Fund Outperformance for Mid 2017
S&P has published it's mid-2017 S&P Indices vs Active (SPIVA) Europe Scorecard. This is a very large-scale international survey performed by Standard and Poor's Dow Jones Indices which attempts to track how many active funds beat their benchmark.
What's the Active vs. Passive Debate?
An active fund is a pool of money collected by a company which it invests on behalf of investors. These funds are "active" because they try to beat the market as a whole. For example if it is a UK share fund it will may try to outperform the UK FTSE 350 index. You pay the active manager to choose the best stocks that will outperform. If the FTSE 350 goes up 10% in a year then your active fund should go up by more than 10% and if the FTSE 350 falls by 10% in a year then your active fund should lose less because it contains "better" stocks. The FTSE 350 would be called a benchmark because it is used as a yardstick to judge how well the fund manager has selected their stocks.
Buying an active fund is a matter of faith. You are entrusting your money to a team of experts who are highly intelligent, who live and breathe the markets and have access to all the latest corporate and market information and research. Investors are split into those who believe that these experts can consistently outperform the market, who I've described as the Alpha Cult, and those who don't. Those who "believe in alpha" pay higher fees than alternative passive funds that simply track the market. Active funds typically cost around 1.3% of the invested amount per year while passive funds can cost as little as 0.07% of the invested amount per year.
Why the S&P SPIVA Report is Important
This debate is very important because investors need to know they're getting what they pay for: outperformance. This is because for almost all active funds the fee is fixed. You pay, say, 1.3% per year whether your fund manager outperforms or not. Now imagine a situation where fund managers, despite their honest best efforts, simply could not outperform the market. You would be paying fees for a service that you are not receiving.
An analogy might be useful. Say a taxi driver promised to get you to the train station but it turned out that there was actually a 50% chance that not only would he fail to get you to the train station, but that he would go in the opposite direction. However you would have to pay his fare whether he gets you to the destination or not. Would that taxi driver stay in business?
This is why it is important to monitor whether active funds are getting us to our destination: generating returns above the benchmark, after we subtract their fees. This is exactly what S&P are trying to measure with their scorecard. The survey counts how many funds of each different type are beating their benchmark over different timescales and consistently generating alpha.
So... how did they do this time?
This table shows the percentage of funds which were outperformed by their benchmarks. Ideally this would be a low number. The rows are fund categories, and the table is split into performance in two currencies: euro and sterling. I've highlighted the performance of European funds in euros, the performance of UK equity funds overall in sterling and UK Small Caps (smaller companies with smaller market capitalisation, which is the product of the number of shares outstanding times the share price).
Europe has performed a great deal better than last year when around 80% of funds underperformed their benchmark. Performance is now 50:50, so half of active funds outperformed this year. Imagine if your taxi driver decided whether to drive in the correct direction by tossing a coin...
It's not all negative news. UK Small Caps did extremely well, as this part of the UK stock market put in a strong performance. However, this is unlikely to persist. Looking over a longer time-period, the percentage of UK Small Cap funds that underperform falls to 50% over three years, then 61% over five years and 74% over ten years. This may also explain the strong performance of UK equity funds overall as those with a Small Cap tilt would have benefited from this rally.
Remember that it's long-term performance that separates skill from luck.
Here's a link to the full report:
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